#40 - The R Word

“It’s inevitable…. a deep and protracted period of global economic downturn is unavoidable at this stage” pronounces the latest economist to grace the stage on CNBC. I love how these Inspector Clouseau’s of the finance world get paid considerable sums of money to attest to the obvious. Its like turning up at a funeral and declaring (in your best French accent) “but Monsieur, I think this man is dead.”

For the avoidance of doubt, the likelihood of a period of economic carnage has been on the cards for a while now and long before anyone in China inexplicably contracted the now infamous COVID-19. Cheap and too readily available money, expensive yet completely entrenched company valuations and lethargic global volatility have all been conspiring to kick the world in the nuts at the next convenient opportunity. Well guess what sports fans…that time has arrived.

Now I have neither the qualifications nor the gumption to confidently call how things play out over the next couple of years. That’s partly because I believe there are a number of scenarios with substantially differing outcomes which could happen. What I will give however, is my subjective view on the net impact of all of this for the car market.

But first a brief economics lesson; When we talk about inflation it is important to differentiate between Nominal and Real.

Nominal Inflation in isolation is not a problem. As long as the price rises are matched or bettered by Nominal Wage Growth….we are all good.

What we actually need to be focusing on is Real Inflation or better explained the Real Cost of Living. The headache occurs when nominal inflation outstrips nominal wage growth thus creating a situation where your cost of living is increasing at a faster rate than your income meaning you are fundamentally worse off….or negative real wage growth as the Clouseau’s of the world like to refer to it.

The components that are driving this negative real wage growth are important but also irrelevant as the GO TO central bank answer to this problem has for decades been the same; raise rates, reduce consumer demand/increase saving, reduce nominal inflation….all carried out with a sprinkling of government spending.

 So that’s the job done right? The world goes back to normal and everybody is happy?…..well no not exactly.

You see while inflation started as demand pull (demand outstripping supply) due to cheap money and low interest rates through lockdown, in this instance it quickly shifted to cost push inflation implying a lack of supply and increase in input prices were the cause of the price hikes. This is important because in the same vein as prescribing the correct medicine to address an illness, an incorrect prescription can potentially make the illness worse and that’s where we are now in an economic sense.

Raising rates is great for addressing demand pull inflation but terrible for fixing supply push inflation as it doesn’t fundamentally address the core issue. In fact, it actually exacerbates it in the long term. This is especially true for an economy which is over levered due to a decade of exceptionally low borrowing costs. So, let’s talk cars….

Back in August 2019 (Market Musings #9  - Is Car Finance Subprime 2.0?) we talked about the inherent risks of the current car finance market. To recap, high LTV on a depreciating asset over a medium term time period works great in a bull market, less so in a recessive environment. This is proliferated by the very high valuations on those assets being financed in the first place.

Now the effect of interest rate increases isn’t actually felt straight away as the vast majority of borrowers are typically locked in to a fixed rate. No, the headache remains dormant until that point in time when the borrower needs to consider their refinancing options. The cost to refinance has suddenly become significantly higher meaning what was an affordable finance backed asset purchase at the time is now less so and coupled with other increasing finance costs (mortgage etc), owning said car is now no longer a viable option. So the borrower sells the car and possibly buys something cheaper or goes without car completely.

The concern here is that this is not an isolated incident…its systemic. There will be thousands if not millions of people having the same discussion. So it no longer is a couple of cars being sold, its hundreds of them and combined with new car supply issues eventually being addressed, the market will literally be flooded with supply and no one really looking to snap it up.

Now at this point I think its very important to differentiate between the two subsections of the car market we deal in. Your nearly new sports/supercars and the collectable car market (both modern and classic). The reason I want to differentiate is not only because their leverage profiles are very different but also because their fundamental intrinsic values are also markedly unique.

In the nearly new sports/supercar section, the amount of leverage (borrowing to finance the car purchase) is a lot higher. Sadly, I don’t have an exact figure (please share if you have) but I would hazard a guess that 2/3rds to 3/4qtrs of the purchases made in this segment of the market are via financing of some sort. Combined with toppy market valuations, a substantial correction to the downside in prices over the next couple of years is unavoidable. That combined with the likelihood of chunky negative equity in a lot of those deals makes the outlook for that side of the market quite horrific if I’m honest.   

Flip over to the collectable car market and it is a very different picture. Leverage is much lower with far more cars being purchased outright with little to no finance. Funnily enough, leverage in this market concerns me far less anyway because of the fundamental value of the cars being underwritten. Whether it is a BMW M3 CSL or a Renault Clio V6 or a Ferrari 599 GTO, their value is derived from several things including their rarity and uniqueness which historically are much more robust and hold up better in turbulent times.

Now I am not saying for a second that the collectable car market will be impervious to the broader macro-economic forces currently at play, but I do believe it will weather the storm infinitely better over the coming years even simply as a point of value preservation and protection.

I said at the start I had no interest in trying to call the outcome of the economic events currently unfolding in front of us. The dislocation between equity and bond markets is concerning but also suggests a belief that a global recession is not a fait accompli. That said, what I do believe is that the interest rate trajectory central banks currently find themselves on will be hard to deviate from. That ultimately means my opinions regarding the car market are also reasonably probable as I consider it in a lot of ways more a function of the credit market than equity world.

So without trying to talk our book, we as consumers and car lovers have several options to contemplate right now. We can go out and pay £30k over list to get our hands on a new Range Rover….I hear residual values are bullet proof! Or we could sit still and watch things play out paralysed by the uncertainty and our deep-rooted love of risk aversion…Theta decay has never been more prevalent. Or we could logically find tangible assets with real long term intrinsic value and buy them. I know what we will be doing.

Happy Motoring,

Greg